Derivatives, the Financial Crisis and Risk Management Clark L. Maxam Trailcrest Capital Advisors, LLC

Background Derivatives are not new – first rice derivative contracts traded in the 18th Century. Commodities derivatives have been actively used for more than 100 years. Financial Derivatives have existed for hundreds of years we just called them “contracts”. Purpose is risk transfer, risk reduction, “Insurance”

Derivatives - Definition A financial contract that derives its value from an underlying asset. Classic Examples: Futures and Forwards Options Less Classic Examples Plain old equity/stock – derives its value from the underlying assets and prospects of a firm. Some argue all securities are derivatives Bonds derive their value from the underlying credit of the borrower (ability to pay). A stock can be viewed as an option on the firms assets. By counter example, real cash traded assets are not derivatives – Gold, wheat etc., but contracts for the exchange of real assets in the future are derivatives. More recently Credit Default Swaps (CDS) and a host of others All are combinations and/or variants of futures and options when properly understood. Underlying assets are changing in value minute to minute, day to day which means the derivative contract changes in value as well.

Futures and Forwards An agreement to buy or sell a specified quantity of an asset at a specified price at a specified time and place. Classic example: Farmer Plants wheat in the Spring Doesn’t know what the price will be at harvest Wheat futures contracts allow him to “pre-sell” his crop at a price he can know now.

Futures Example - Farmer Expects 10,000 bu harvest in September. The current “spot” or cash price if he could deliver today is $7.78 bu. He is LONG wheat September Futures contract price is $8.35 for 5000 bu. Farmer “sells” his wheat for future delivery at $8.35 by selling the Sept. futures contract knowing that this price will guarantee a comfortable profit and proceeds to sleep soundly for the next 4 months. He is SHORT a futures contract.

Futures Example: Farmer Suppose in Sept. the cash price of what is $6 per bu. Farmer sold his contract at $8.35. Rather than transport his wheat to Chicago, he sells it at the local elevator for $6 per bu: sounds bad? BUT, he can “cover” his wheat contract by buying it back in the futures market. What will the price be? May: Sells 2 contracts (10,000bu X 8.35 = $83,500) Sept: Sells 10,000 bu X $6 at the elevator = $60,000 Buys 2 contracts back at $6 (10,000bu X $6 = $60,000) Net: Sold 2 contracts for $83,500, bought them back for $60,000 Sell high, buy low  PROFIT = $23,500 Sells Wheat at elevator for $60,000 Total Proceeds $83,500 In fact, no matter what happens to wheat price he sells for $83,500! His price risk has been eliminated.

Risk/Return Trade-off THE RISK IS LOWER BY UTILIZING THE WHEAT FUTURES CONTRACT, BUT THERE IS NO FREE LUNCH – YOU ALWAYS GIVE UP SOMETHING TO GAIN SOMETHING. In this case, you are willing to forgo higher wheat prices in return for protection against lower wheat prices.

Options The right, but not the obligation to buy (call) or sell (put) an asset at a specified price at or prior to a specified date. AAPL = $345 What is the right to buy Apple at $1,000/share worth? What is the right to sell Apple at $1,000/share worth? An important question is how long or over what period? 1 day? 1 month? 1 year? 25 years? Time adds value to the option, more time = more risk = more value.

Call option

Put Option

Alphabet Soup of Derivatives CDS, CDOs, CLOs, CMOs, CMBS, RMBS, etc. are all derivative securities and essentially combinations of futures and options concepts. If you really understand futures and options then you can understand ANY derivative security.

Notional Stupidity $600 Trillion in notional derivatives outstanding! This counts both long and short positions and double/triple/multiple counts notional/nominal position value that may have little relation to actual market risk. Eg. A 1 month option to buy AAPL at $1,000/share trades for $0.001 per share. You decide what the hell and spend $100 buying 100,000 shares worth. The notional value of your position is 100,000 shares of AAPL at $345 per share or $34,500,000! The guy who sold them to you also has a notional option position of $34,500,000 for a total notional position in the market of $69 million! What is your total risk? $100!

A Digression So what about all of this WMD stuff? First Rule of Real Estate? Location, Location, Location! First Rule of Financial Blow-Ups? Leverage, Leverage, Leverage! Second Rule of Financial Blow-Ups? Incentives, Incentives, Incentives Well intended (?), but disparate rules and laws coupled with banking regulation created a set of market incentives that encouraged market behaviors that led to an unprecedented increase in financial leverage using derivatives. Blame the person pulling the trigger not the gun.

The Subprime Timeline

The Subprime Timeline:1992-2002 1992-2002 Massive push for affordable housing – multiple Acts and major policy implementations Fannie Mae, Freddie Mac and private originators pressured to make housing more affordable Agencies ease credit standards and announce programs to buy subprime loans Market responds taking subprime originations from $40B to $230B 1st Securitized Subprime mortgage backed security guaranteed by Freddie Mac Tech Bubble and Sept. 11th result in massive Fed ease, lowest interest rates in 30 year The “HUNT FOR YIELD BEGINS”

The Credit/Capital Requirement Arbitrage Basel Accord: Financial Institutions are required to hold very low or ZERO capital against AAA rated assets. What is the incentive if you can borrow low, invest/lend high and hold NO CAPITAL?! The structured finance innovation (Mortgage backed securities) created AAA securities that yielded MORE than comparable maturity US Government securities. RESULT: They couldn’t create them fast enough to satisfy the GLOBAL demand.

The Subprime Timeline:2001-2006 Rising prices, low rates, and low defaults result in very high profits for first subprime originations Private market rushes in to make loans and securitize directly – non-agency securitization explodes, structured finance innovation Ratings agencies rate senior mortgage structures AAA Very attractive to investors and financial institutions since they pick up yield, but have NO capital requirement. Structured finance “arbitrage” is born – create AAA securities out of everything to satisfy demand for yield and low capital requirement assets (CDOs, CLOs etc.)

The Subprime Timeline:2004-2007 Moral Hazard accelerates as originators can easily sell product into securities markets – push risk on to buyers of securities No Doc, no down, Liars loans proliferate 69% Homeownership up from steady 63% Market recognizes potential for moral hazard, but insufficiently safeguards against it. Late 2006: Market begins to realize extent of mortgage fraud and refuses to securitize mortgages Ownit, New Century Financial bankruptcies – no securitization, no funding. Subprime market shuts down as rising delinquencies and foreclosures threaten even most senior AAA securities.

Subprime Origination and Case-Shiller Home Price Index

Subprime Origination, Case-Shiller and Ownership Rates

Using Derivatives to Manage Risk Derivatives can be used to magnify risk, but Prudent professionals utilize options and other derivatives to control and limit risk. Insurance against downside market movements. Generation of income during market lulls or within price parameters. Creation of modified risk profiles that better meet market expectations than just buy and hold. Utilize combinations of forwards and options to modify and control risk over specific periods of time. As always no free lunch, must give up something to get something.

Questions?

RSG Investment Bank “Trust the ‘really smart guys’ for all of your investment needs” Whew! We better get rid of these foul smelling mortgages. They are starting to stink up my office

The morons at the SEC won’t let us sell this stuff to widows and orphans so we’ll sell it to our sophisticated institutional clients.

Go away, ya botha me

Yeah, I meant to call you but it’s been really crazy around here Yeah, I meant to call you but it’s been really crazy around here. It seems the jerks who took out the mortgages backing your CDO aren’t able to pay them off.

Yeah, that was a bad assumption. We screwed up.

They screwed up too.

But this security was insured! What about the insurer?

Are you kidding? There’s no way they have enough money set aside to cover this mess. They screwed up.

Well that’s just great, you nimrod, what am I supposed to tell my villagers?

Tell them you screwed up

Screw you

Screw you